a)
Despite Modigliani and Miller’s (MM) argument that dividends are irrelevant, dividend
payments have tended to smoothen over the years rather than take the expected random pattern.
Explain three theories which support dividend payments
b)
[10 Marks]
The fundamental theorem set forth by Modigliani and Miller is that, given complete and perfect
capital markets, it does not make any difference how one splits up the stream of operating cash
flows. The percentage of debt or equity does not change the total value of the cash stream
provided by the productive investments of the firm. Therefore, so long as there are no cost of
bankruptcy it should not make difference whether debt is risk free or risky
Required
Using Rubinstein [1973] mean variance framework provide a proof that risky debt and risky
equity have no impact on the value of the firm
c)
[10 Marks]
Using the simple binomial trees, calculate the value of a call option with the following
characteristics:
Underlying asset current value = 1,000
Option exercise price = 1,250.
Per-period dividends =10% of asset value
1
Up movement per period = 1.5, d=1/u.
Risk-free rate =10%
Time to expiration= 2years.
Number of time periods per year=1
[11 Marks]
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